The composite Eurekahedge Hedge Fund Index returned a robust 1.81% for the month of October and 8.5% for the year to date. The month’s performance was driven by a strong rally in equities on the back of a healthy earnings season in Q3 (the MSCI World Index returned 3.7% for the month), and to a lesser extent, by a rally in metals (owing to constrained supply conditions). On the other hand, some of the economic data emanating from the US for Q3 2006 – multi-year lows in the growth in residential housing constructions (-17%) and GDP growth estimates (1.6%) – triggered reversals in global fixed income and currency markets; bond prices rallied and the US dollar weakened on expectations of lower future US interest rates. While the economic slowdown in the US continues to be a cause for concern, the Federal Reserve has left the short-term interest rate unchanged for the third consecutive month in a bid to see if the slowing economy slows inflation. The downward pattern in crude prices has also helped tame inflation.
The month’s price movements in the energy and currency markets also proved, in the main, profitable for hedge funds. Crude oil prices continued their fall on high inventory levels, while natural gas prices recovered some of September’s losses. In currencies, the US dollar strengthened early in the month against the euro and the Japanese yen, but weak economic data and a status quo in the Fed interest rate meant a reversion back into recent ranges by the month’s close.
The major geo-political events during the month – North Korea’s first nuclear test and the coup in Thailand – had little impact on price movements in the global financial markets. These market movements afforded opportunities to trend followers, value traders and arbitrageurs alike. As a result, the superior returns of the composite Eurekahedge Hedge Fund Index were also broad-based as can be seen from the performance of the component strategy indices in the graph below.
Given that the key driver of hedge fund returns during the month was the rally in equities, comparing the returns of the S&P500 Index (+3.3%) with those of the MSCI Emerging Markets Index (+4.7%) goes some way in explaining the pattern of returns seen among the regional components of the Eurekahedge Hedge Fund Index (see the graph below). The best returns during the month came from managers allocating to the emerging markets in Asia (+3.4%) and Latin America (+2%), while their North America- and Europe-focused peers rose about 1.5% on average. The weakest performers for the month were Japan-focused managers (+0.4%), which was largely in step with the modest gain in the TOPIX (+0.4%), as the markets were governed by few clear trends and low volumes.
The Eurekahedge North American Hedge Fund Index returned 1.4% for the month, with positive to robust returns across all strategies. The month’s best-performing strategies were relative value (+3.1%), distressed debt, event-driven (+2.2% each) and multi-strategy (1.9%) funds. Relative value players were profitable across equity and currency markets, for instance, long positions in the month’s high-yielding currencies and pair trades in specific sectors and situations.
Special situations players such as distressed debt and event-driven managers had a good run too; the high yield market rose (+1.5%) for the fourth consecutive month in October on the back of tightening credit spreads, active new issuance and some LBO/merger–fuelled names. Also, M&A activity continues to be healthy and spreads are at attractive levels. There were a number of Canadian or Canadian cross-border situations during the month, such as the acquisition of Canadian energy exploration company Rider Resources by Shiningbank Energy Income Fund. Another profitable situation was the acquisition of Global Signal Inc by Crown Castle International, which sent the acquired’s stock up by 8%.
On the other hand, arbitrageurs, especially convertible arbitrage and volatility arbitrage managers, had a relatively calm month owing to the low volatility across markets (the volatility index, VIX, fell from 11.98 to 11.10 during the month). Convertibles players who had a decent run for the year to date, paused in October to secure profits, and convertible valuations cheapened as a result. New convertibles issuance too was lower than expected, with announced deals mainly smaller-sized and adding up to about US$6 billion globally and US$2.8 billion in the US.
The US treasury market was flat during the month as ten-year yields fell from 4.64% to 4.61%, and five-year yields dropped from 4.59% to 4.57%, resulting in an essentially flat yield curve. Consequently, fixed income managers had a mildly positive month at gains of 0.3%.
Eurekahedge North American Hedge Fund Index
European hedge funds had a terrific run in October (+1.8%) with all strategies closing the month in positive territory, on the back of strongly performing equities (the MSCI Europe Index rose 4.2%), continued high levels of M&A activity, rise in business confidence (particularly in Germany and France) and increased investor risk appetites as evidenced by the solid performance of emerging markets, small-cap and other perceived high-risk asset classes. The performance of Turkish stocks, despite setbacks on EU accession front, is a good example.
Gains in the equity long/short strategy (+2%) came mainly from the materials, industrials and retail sectors and the Norwegian, Austrian and Spanish markets.
Event-driven managers (+1.5%) too benefited from the boost to M&A and IPO activities given by the strong earnings and cash-flows in the region. For instance, the German utilities company, RWE, has agreed to sell Thames Water to Kemble Water (Macquarie’s European arm) for £8 billion.
Fixed income managers posted decent returns (+0.9%), gaining more through the long/short and carry styles than through arbitrage. This was owing to the tightening spreads and difficult bond markets given the conflicting economic data and the uncertainty over Fed policy. Arbitrageurs in general too posted modest gains (+0.2%) in an environment of low volatility.
Eurekahedge European Hedge Fund Index
The Eurekahedge Japan Hedge Fund Index rose a modest 0.4% for the month. Japanese equities had a turbulent month beginning with reports of large redemptions, especially in small-cap stocks, on concerns of a slowdown in global growth. This effectively narrowed the gap in valuations between large-cap and small-cap stocks, and coupled with positive earnings news, this helped recover the early losses, before reversing course downward again on the back of weak US economic data and domestic inflation data. Furthermore, the markets were low on trading volumes, with much of the activity concentrated around foreign demand related stocks which were sensitive to the yen-dollar exchange rate. As a result, equity long/short funds had a largely flat month (+0.1%).
The weak economic and inflation data also triggered rallies in the bond and currency markets towards the end of October, which had till then been the mirror image of the equity market movements. In the ultimate analysis, these swings hurt relative value and multi-strategy players in the region as well.
The Asian equity markets excluding Japan rallied strongly in October (the MSCI Asia ex Japan index rose 4.6%), on the back of supportive global macroeconomic data and the surge in liquidity flows into the region. That said, the rationale behind these inflows remained market-specific.
For instance, October saw a steady stream of inflows into Chinese equities, as suggested by the heavily overbought IPOs from China. The Industrial and Commercial Bank of China alone raised over US$20 billion during the month, becoming the world’s largest new issue to date. The Hang Seng Chinese Enterprise Index (the ‘H-Share Index’) rose a solid 5.5%, with large-cap stocks like China Mobile and HSBC leading the rally.
Australian equities (+4%) also rose to multi-year highs during October, and saw a marked increase in M&A activity. Two notable events in this regard were 1) Mexican cement maker Cemex making a A$16.8 billion cash bid (the largest in Australia’s history) for local building materials supplier Rinker Group; and 2) the A$7.9 billion merger between two of the country’s bigger financial services houses, Suncorp and Promina.
This trend of soaring equities (the S&P Nifty index rose a stellar 6.4%) and huge liquidity inflows (the month saw Foreign Institutional Investor inflows to the tune of US$1.7 billion) was also a dominant theme in the Indian markets. The earnings data released during the month show robust growth across most sectors.
With global crude oil prices on the low, the US economic slowdown and a pickup in foreign investment inflows, most regional currencies strengthened against the US dollar. Indeed, export-heavy North Asian markets such as South Korea and Taiwan hurt exporters in these markets. Apart from the general trend of rallying equities, this was another reason for the robust performance of equity long/short funds in the region – Taiwanese and Korean equities afforded these funds profitable shorting opportunities as well. The equity price movements and corporate events in the region also helped other opportunistic and directional players such as arbitrage, event driven and relative value.
Fixed income funds also had a terrific month (+1.6%) on the back of a strong rally in the region’s fixed income markets. The broad-based rally (encompassing cash bonds, CDS and local currency bonds) was triggered by a smoother-than-expected slowdown in the US economy coupled with the Fed’s decision to keep the short-term interest rate unchanged for the third consecutive month. Fund managers gained from the spread tightening (high-yield spreads tightened by 50 to 100 basis points) and from the coupon income through the arbitrage positions.
The Latin American markets had yet another month of impressive returns (The MSCI Latin America Equity Index rose 7.7%), fuelled by strong earnings data across the board.
In Brazil, President Lula was re-elected and the Central Bank continued to lower rates. Given the falling interest rates and improving economy (very strong Q3 results, for instance), the dynamic of good companies at attractive valuations is driving liquidity back into these markets. The Ibovespa, the Brazilian equity market index, was up a whopping 9% for the month. This and other corporate situations such as the ongoing consolidation in the Cable TV and broadband services sector, which still has poor market penetration in Brazil, have contributed to the stellar performance of equity long/short funds in the region (+3.1%).
Mexico’s inaugural local-currency, 30-year maturity bond issuance was offered below the existing ten-year yield owing to heavy demand, and triggered a downward adjustment in the yield curve. This is turn led to a broad-based rally in the currency and interest rate markets.
The combination of clearly trending markets, attractive valuations and inward liquidity flows has led to healthy gains across all strategies among Latin American hedge funds.
Financial markets continue to appear divided on future growth prospects; the fixed income markets are forecasting lower growth and lower interest rates, while the equity markets are reflecting a very strong earnings season in Q3 2006. Given the uncertainty that still surrounds the Fed’s actions with respect to interest rates and inflation, the overriding theme among hedge fund managers is of ‘cautious optimism’. The optimism is also warranted by the improving macroeconomic variables in several of the emerging markets such as Brazil, Argentina, China and India.
While on the face of it, Japan continues to be the only region bucking the general global trend, this can be put down to a case of nerves – investor confidence in the economy’s ability to re-accelerate needs to return.
Weighing the positives (improving housing sector, stronger employment growth and the benefits of a weak yen) and negatives (weakness in bank lending spreads, adverse effects of sluggish consumption and high inventories on industrial production), the cautious optimism extends to the Japanese markets as well.
1Based on 56% of the NAV returns for Oct-2006 as at 14-Nov-2006.
2The Eurekahedge Japan Hedge Fund Index is a separate index and derives its value not only from the actual performance of the listed strategies for the investment region but also from the strategies which are not listed (due to strict Eurekahedge indices guidelines) but having the same investment mandate.